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Portfolio Management:

Costco’s investment portfolio.

Hanh Thuy Hong Nguyen

School of Business and Management, City University of Seattle

FIN551_D01_MM: Quantitative Methods and Economics for Finance

Seattle - Winter 2020-2021

Professor Anthony Petersell

March 10, 2021

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Abstract

This article aims to select, evaluate, and manage specific portfolios of Costco stocks

(NASDAQ: COST). The report applies financial indicators, valuation theory including free

cash flow to the firm (FCFF) model to predict the future cash flow of a portfolio. Besides,

the article also mentions the benchmarks, profitability, and the risks if any in making the

decision to hold this portfolio.

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Business Overview

Costco Wholesale Corporation is one of the world's leading trade retailers for

membership warehouse chains (Costco Wholesale Corporation SWOT Analysis, 2020). The

company is offering quality, competitively priced products with a wide range of hardlines,

softlines, food, pharmaceutical, consumer goods, and gas stations through its Kirkland

Signature brand. The company currently has 785 stores in 10 countries worldwide (United

States, Puerto Rico, Canada, the United Kingdom, Mexico, Japan, Korea, Australia, Spain,

France, Iceland, China, and Taiwan). In 1983, Costco was established in Seattle,

Washington, USA.

Costco is running a warehouse club model with a stable income with 98.5 million

loyal members. In addition, the e-commerce platform also helps Costco connect online

members and provide additional service products such as Costco Travel, Costco Insurance,

Auto Parts, and Service (Costco, 20120). Total revenue in 2020 increased by 9.2% and

reached $ 163 billion. In which, membership card fee revenue accounts for 2%, online sales

account for 6% of the total revenue. Gross profit increased 10% to reach $ 21.8 million.

Costco is also implementing Nebraska poultry processing systems and organic vegetable

gardens in California to supply the sales system. Costco is the Best Company Perks &

Benefits and Best Company Happiness (Costco Awards, 2021). To achieve this success,

Costco has built a stable growth strategy based on systematizing the supply chain,

standardizing the quality of products and services to deliver customer satisfaction without

any program. any advertisement. Costco (NASDAQ: COST) always holds the top 15 of the

S&P 500 and is one of the growth stocks that most investors want to own.
COSTCO’S INVESTMENT PORFOLIO 4

Industry Overview

The wholesale industry has high competition, a moderate level of technology

change, and a focus on price, quality of products and services, as well as customer loyalty

(Fernandez, 2020). Costco competes with warehouse clubs such as Walmart Inc. (Walmart

Supercenters, Sam's Club), BJ's Wholesale Club Inc, Meijer Inc., and retail supermarkets

such as Target, Kroger, and Amazon. The total market is worth $ 497.4 billion and an

annual growth rate of 2.7% for the period 2020-2025. In which, Walmart accounts for

73.8% and Costco holds a 19.6% market share. The decrease in crude oil price affects

revenue and profit of companies in the industry also increasing slowly (Fernandez, 2020).

Therefore, businesses focus on reducing or minimizing advertising costs, taking advantage

of the economic scale, providing wholesale products, or charging membership fees. In the

future, businesses need to develop and expand their online competition to match consumer

confidence, and the economy recovering from the pandemic will be proportional to industry

revenue. Costco has a highly competitive position with intangible asset potential and cost

advantage. Costco's membership renewal rate of 90% globally shows a distinct position in

growth and effective customer retention (Fernandez, 2020). The warehouse system allows

for bulk cargo storage for efficient, quick-managing transportation as it has tripled its real

estate performance and reached $ 1,400 in sales per square foot. This contributes to

confirming that Costco's distinct warehouse business model is effective despite the impact

of the Covid 19 pandemic and the fierce competition in the expanding e-commerce model.

Financial Ratio Analysis

According to Costco (2020), the income statement and balance sheet in 2020 on the

fiscal year ended on August 31, 2020, financial ratios show liquidity and profitability are as
COSTCO’S INVESTMENT PORFOLIO 5

below:

Liquidity ratios:

Current ratio = 28120/ 24844 = 1.13 (increase 11% compared to 2019

Quick ratio = (12277 + 1028+1550)/24844 = 0.59 (increase 25% compared to 2019).

Time interest earned ratio = 5435/160 = 33.9.

So, Costco should boost sales and inventory turnover and pay off liabilities to

improve these ratios.

Solvency ratios:

Debt to equity ratio = 36851/18705 = 1.97 (increase 20% compared to 2019).

Equity ratio =187050/55556 = 0.33

Debt ratio = 17805/55556 = 0.32

So, Costco has a low debt-to-equity ratio that is more financially stable, so Costco

needs to keep its current debt to equity ratio positions over a long period of time.

Profitability ratios:

Gross margin ratio (GM) = (166761-144939) = 21822/166761=13.08% (increased 0.7%

compared to 2019).

Operating margin ratio (OM) = 5435/166761 = 3.25% (increased 4.8% compared to 2019).

Profit margin ratio = 4002/163220 = 2.45%

Return on assets ratio (ROA) = 4002/ (55556+45400)/2 = 7.92%

Return on equity ratio (ROE) = 4002/ (15243+18284)/2 = 23.87%

Return on capital employed ratio (ROCE) = 5435/ (55556 – 24844) = 17.69%

So, Costco should reduce cost such as goods sold, labor costs, and operating costs.

Besides that, ROA is 7.92%. It shows shareholders receive a 7.92% return on their
COSTCO’S INVESTMENT PORFOLIO 6

investment in assets. Costco should continue to promote its ability to effectively manage its

assets and generate greater amounts of net income. ROE is 23.87%. It shows that Costco has

23.87 cent profit in 2020. Costco’s ROE is higher than the average requirement and they

should continue to use investors' money effectively. ROCE is 17.67%. It shows that Costco

shareholders receive a return of 17.67% from their used capital. This shows the overall

impact of the pandemic on the retail industry, but Costco only decreased by 17% compared

to the same period in 2019. Costco's business health and financial ability are quite good. It

also encourages investors to hold or buy Costco stock.

Efficiency Ratios:

Receivable turnover ratio = 166761/ 1550 = 107.58 times

Inventory turnover ratio = 144939/ (11395+14242)/ 2 = 12.26 times

Asset turnover ratio = 166761/ (55556+45400)/2 = 3.3

Interest coverage ratio (IC)= 5435/ 160 = 33.96 times

Days in inventory ratio = (11395+12242)/2 / 144939) * 365 = 29.76

Costco's ability to collect receivables is very efficient and can easily turn inventory

into cash. Costco's income can also cover the full cost of bank interest. Costco also asserted

its competitive advantage over rival Walmart Stores Inc when their Accounts Receivable

Turnover was 83.38 times and Inventory Turnover was 8.54 times by 2020. Dong At the

same time, Costco used its assets to generate revenue quite effectively when it was 2.75

times higher than the industry average. In general, based on daily inventory indexes,

accounts receivable turnover ratio, inventory turnover, asset turnover shows that Costco's

cash conversion cycle is quite good and exceeded expectations.

COSTCO’S INVESTMENT PORFOLIO 7

Investment portfolio overview

Firstly, evaluating the profitability of an investment in the future requires two factors

which are Free Cash Flow (FCF) and Aggregate Annual Growth Rate (CAGR).

Historical FCF of Costco from 2016 to 2020 (Million)

Year 2017 2018 2019 2020

FCF 4224 2805 3358 6051

Source: Costco (2020)

CAGR = (Ending value/ Beginning value) 1/no. of years) -1

= (FCF2020/FCF2017 1/5-1 = (6051/4224)1/5-1 = 0.0745 = 7.45%

According to the historical FCF of Costco and CAGR from 2016 to 2020, Costco’s

FCF forecasted next five year is below: FCFn+1= FCF2nx (1+CAGR)

Year 2021 2022 2023 2024

FCF forecast 6501.79 6986.17 7506.63 8065.57 million.

So, Costco’s FCF forecasted from 2021 to 2024 will increase slightly and reach

$8065.87 million in 2024. It is a positive number for investors to hold or buy stocks during

this period.

Portfolio Performance Valuation

Using Free cash flow to the firm (FCFF)

Weighted Average Cost of Capital (WACC) measures the ability to pay all the

securities, stocks, and bonds to finance a company's assets.

E (market value equity = 323.4 x 442.955= 143251million; D = market / book value of the

Costco’s debt = 8495 million; Ke (cost of equity) = 1.47% +0.57 *6% = 4.89%; K d (cost of

debt) = 160/8495 = 1.88%; t = effective tax rate = 24.9%

COSTCO’S INVESTMENT PORFOLIO 8

WACC = 143251/ (143251+ 8495) *4.89% + 8495/ (143251 + 8495) *1.88%*(1 – 24.9%)

= 4.69%

Source: DCM model (2021)

A positive Costco's Free cash flow to the firm (FCFF) indicates a thriving firm that

generates revenue and income in the current environment. Costco has enough cash to

expand, develop new products, buy back stocks, and pay dividends. It is also an important

indicator to confirm that holding the value of COST shares in the investment business is

completely correct.

Using the Equity market valuation

COSTCO’S INVESTMENT PORFOLIO 9

Market value = 324.4*444000=$144033.6 million.

Enterprise Value preferred stock = 0; long-term debt & capital lease obligation = $10103

million; short-term debt & capital lease obligation = $96 million; minority interest = $400

million; cash, cash equivalents, marketable securities = $14423 million.

Fundamental value of Costco = $144033.6 + 0 +$10103 + $96 + $400 - $14423 =

$140209 million

The market value of Costco is higher than the fundamental value of Costco. However,

Costco’s competitors like Walmart had a market value of $361207 million. Therefore, the

investors expect Costco to increase market value through work research and develop a

brand, change market position, form a growth alliance strategy, and retain key employees.

Benchmark Comparison

Company Revenue EBITDA Annual Market Intrinsic ROIC WACC

growth% growth% Total Price Value

Return
Costco 8.7 8.7 20.10% $382 $ 284.87 12.81% 4.26%

Target 7.9 4.2 14.63% $169.56 $103.67 12.59% 6.12%

Walmart 5.4 3.6 13.71% $150.4 $115.41 8.73% 3.39%

Amazon 25.6 42.2 34.75% $3142.4 $2835.4 11.37% 9.48%

Source: S&P 500 (2021)

According to S&P 500 (2021), in the period 2010-2020, Costco has an 8% growth in

sales, an average annual gross profit of 20.10% and maintains the highest level of economic

profit in the retail industry. According to Costco net promoter score 2021 benchmarks

(2021), Costco's net promoter benchmarks is 79 while the consumer trade industry average

is 24. A net by industry promotion benchmark that measures customer satisfaction and

loyalty with the Costco brand is very high and it helps businesses increase sales, develop
COSTCO’S INVESTMENT PORFOLIO 10

brands more deeply.

Now, Costco's revenue and earnings growth ratios are fairly stable as operating

income hits $ 5.4 billion by 2020, and a stock dividend yield of 0.8 percent. Shares Costco

(COST) meets two potential factors to increase prices and increase income from dividends.

Therefore, Costco becomes an attractive and wise investment stock (Rothman, 2021).

Standard deviation and Risk analysis

Monthly rates of return

Costco Wholesale Corp. (COST) Standard & Poor’s 500 (S&P 500)
t Date Price(COST, t) Dividend(COST, R(COST, t) Price(S&P 500, t) R(S&P 500, t)
t)
Jan 29, 2021 352.43 3,714.24
1 Feb 1, 2021 $350.52 -0.54% 3,773.86 1.61%
2 Feb 2, 2021 $355.58 1.44% 2,826.31 -25.11%
3 Feb 3, 2021 $355.21 -0.10% 3,830.17 35.52%
4 Feb 4, 2021 $355.85 $0.70 0.37% 3,871.74 1.09%
5 Feb 5, 2021 $355.17 -0.19% 2,886.83 -25.44%
6 Feb 8, 2021 $359.83 1.31% 3,915.59 35.64%
7 Feb 9, 2021 $359.56 -0.08% 3,911.23 -0.11%
8 Feb 10, 2021 $356.12 -0.96% 3,939.88 0.73%
9 Feb 11, 2021 $352.20 -1.10% 3,916.38 -0.60%
10 Feb 12, 2021 $352.75 0.16% 3,934.38 0.46%
11 Feb 16, 2021 $354.00 0.35% 3,934.83 0.01%
12 Feb 17, 2021 $358.04 1.14% 3,932.59 -0.06%
13 Feb 18, 2021 $356.92 -0.31% 3,931.33 -0.03%
14 Feb 19, 2021 $354.77 -0.60% 3,913.97 -0.44%
15 Feb 22, 2021 $350.21 -1.29% 3,906.71 -0.19%
16 Feb 23, 2021 $342.15 -2.30% 3,876.50 -0.77%
17 Feb 24, 2021 $340.70 -0.42% 3,881.37 0.13%
18 Feb 25, 2021 $333.90 -2% 3,925.43 1.14%
19 Feb 26, 2021 $331.00 -0.87% 3,829.34 -2.45%
20 Mar 1, 2021 $331.77 0.23% 3,811.15 -0.48%
Average (R̅ ): -0.29% 1.03%
Standard deviation: 0.96% 14.14%
Variance 0.01% 2.00%
Convariance 0.01%
COSTCO’S INVESTMENT PORFOLIO 11

Systematic risk estimation

Variance 0.01%
Variance 2%
Convariance 0.01%
Correlation coefficien -0.03
βCOST 0.005

According to monthly rate return and risk estimation, the portfolio return is negative.

The decrease in the price of Costco shares in the first quarter of 2021 is an opportunity to

buy and hold to wait for future price increases (McCall, 2021). The main reason is the

pandemic impact on the global economy that slows Costco's growth. The closure of stores

and the reduction in the way society has reduced sales. However, business activity still grew

9% in the first quarter due to a profitable business model from membership fees and

competitive prices. In addition, Costco's share price is always kept at a high level, thus

avoiding selling-off by investors, so it also avoids making outstanding stock prices such as

GameStop. Stable growth again after the pandemic will be a solid belief for investors to

continue holding COST stock.

COSTCO’S INVESTMENT PORFOLIO 12

References

Costco Awards (2021). Comparably. Retrieved from

https://www.comparably.com/companies/costco/awards

Costco net promoter score 2021 benchmarks (2021). Customer Guru. Retrieved from

https://customer.guru/net-promoter-score/costco

Costco Wholesale Corporation SWOT Analysis. (2020). Costco Wholesale Corporation

SWOT Analysis, 1–7.

Costco (2020). Form 10-k 2020. Retrieved from https://sec.report/Document/0000909832-

20-000017/

DCF model tutorial with free Excel (2021). Business valuation.net. Retrieved from

https://www.business-valuation.net/methods/discounted-cash-flow-analysis/

Fernandez, C. (2020). Warehouse Clubs & Supercenters in the US. IBIS World. US Industry

(NAICS) Report (NAICS) 45291. Retrieved from https://my-ibisworld-

com.proxy.cityu.edu/us/en/industry/45291/about

McCall, M. (2021). Costco Stock Is an Easy Buy on the Dip. Nasdaq. Retrieved from

https://www.nasdaq.com/articles/costco-stock-is-an-easy-buy-on-the-dip-2021-03-01

Rothman, L. (2021). You're smart to stock up on Costco. Nasdaq. Retrieved from

https://www.nasdaq.com/articles/youre-smart-to-stock-up-on-costco-2021-02-26

S&P 500 earnings, week of March 1: Costco, gap to report (2021). S&P Global Market

Intelligence. Retrieved from https://www.spglobal.com/marketintelligence/en/news-

insights/latest-news-headlines/s-p-500-earnings-week-of-march-1-costco-gap-to-

report-62903743